New taxation rules impacting transfers of family businesses to the next generation; Everything you thought you knew about intergenerational transfers is now wrong

June 30, 2021 | Stephen Sweeney, William J. Fowlis, Catherine (Cathie) Brayley

Owners of family small business corporations, family farming and fishing corporations, especially those contemplating intergenerational transfers of those businesses, should take note of a significant change to Canada’s tax laws designed to “level the playing-field” between related-party and arm’s-length transfers. Bill C-208 (the “Bill”), a Private Member’s bill to amend the Income Tax Act[1] (the “Act”), received Royal Assent on June 29, 2021.

The Bill makes substantive amendments to two provisions of the Act, namely sections 55 and 84.1. Amended section 55 will enable siblings to access the related-party exception to the capital gains-stripping provisions in subsection 55(2) of the Act. Amended section 84.1 will, in limited circumstances, deem a non-arm’s length transaction to be an arm’s length transaction. Upon the Bill coming into force, a shareholder selling shares of qualified small business corporations, family farming and fishing corporations can access capital gains treatment whether the purchaser is a corporation owned by a child or grandchild, or by an unrelated third-party, if certain conditions are met.

Background – Section 84.1, Surplus Stripping and Intergenerational Transfers

For the purposes of the following discussion, it is assumed that all individuals and corporate entities described are resident in Canada.

Generally, a taxpayer can sell shares of a business corporation that are capital property of the taxpayer to an arm’s-length third party and have the gain on the sale taxed at capital gains tax rates.[2]

Section 84.1 of the Act is an anti-avoidance rule. It is designed to prevent corporate surplus that would be taxed at dividend tax rates[3], if that surplus were distributed to a taxpayer as a dividend, from being converted into a capital gain taxed at (lower) capital gains tax rates. Section 84.1 applies where an individual sells shares of a Canadian corporation to another corporation related to the individual.

It has been recognized for many years that the anti-avoidance rule in section 84.1 creates a real impediment to the succession of family businesses from one generation to the next. Specifically, where a parent sells the shares of a family business corporation to her child’s corporation, what would have been the parent’s capital gain on the sale is converted to a dividend and taxed at the higher dividend tax rates.  Further, where a parent sells the shares directly to her child and utilizes her lifetime capital gains deduction[4] to shelter the gain from tax, and the child later sells the shares to a related corporation, the child would face the same dividend tax treatment, to the extent of the parent’s sheltered gain. Thus, the rule effectively penalizes families where a child uses a corporation to finance the transaction in an effective manner. And this is so even when the child is paying full market value for the shares. This contrasts with the tax treatment that the parent would receive if she sold those same shares to an arm’s length third party. In effect, section 84.1 makes it more tax efficient for parents to sell the business to a third party rather than to their children.

The Department of Finance has long recognized that the issue requires a solution. But the difficulty has always been in finding a balance between facilitating “genuine” intergenerational transfers and inappropriate tax avoidance. The Department of Finance has engaged in consultations with the business and tax advisory community to explore options for resolving this balancing of interests. Those discussions have involved attempts to define and describe the “hallmarks” of true intergenerational transfers. They have also considered possible solutions that follow the “Quebec approach” or the “U.S. approach” to these same issues.[5]

Background – Section 55, Capital Gains Stripping and Related Party Transactions

Section 55 of the Act is another anti-avoidance rule. It is designed to discourage the payment of excessive dividends as tax-free intercorporate dividends from one corporation to another corporation. That can result in converting what would otherwise be a taxable capital gain on the sale of the shares of the payor corporation into a tax-free intercorporate dividend. Subsection 55(2) can operate to convert an excessive tax-free intercorporate dividend into a taxable capital gain in the hands of the corporate dividend recipient. It is a deeming provision. It will apply if one of the purposes of (or in the case of a deemed dividend arising on a redemption of shares one of the results of) the payment or receipt of the dividend is to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of the payor corporation immediately before the dividend. It will also apply if the purpose is to effect a significant reduction in the fair market value of any share or a significant increase in the cost of all properties of the dividend recipient. The provision will not apply to any portion of a dividend that is payable out of the “safe income on hand” of the payor corporation at the time of the dividend.

Notwithstanding the specific mischief subsection 55(2) is intended to address, it has broad application. It can apply to many reorganization transactions that are intended to achieve family business succession purposes and that are not tax-avoidance schemes.

There are specific carve-outs to the re-characterization in subsection 55(2). The first exception will apply to reorganizations of related corporations. The second applies to all corporate restructurings if the very specific conditions of the exception can be met. The first exception is generally available to facilitate the reorganization of family business structures. But tax policy presumes that siblings have separate and independent economic interests. Thus, to prevent what is perceived to be the improper use of the related-party exception, brothers and sisters are, for the purposes of section 55, deemed to deal with each other at arm’s length and not to be related to each other. This can be a significant constraint on family business reorganizations (such as, by way of example, where siblings wish to separate their interests in a family business into separate corporations). And it can sometimes lead to illogical results. For example, for divisive reorganizations involving a parent and children the children can meet the related persons requirement because they are related through the parent. But if that parent dies the relatedness is lost and what would otherwise be an acceptable reorganization between siblings is no longer acceptable.

Bill C-208

The Bill amends both section 55 and section 84.1. Key to both amendments is that they only apply in situations involving a “qualified small business corporation share”[6] or a “share in the capital stock of a family farm or fishing corporation.”[7]

The specific changes made to the Act upon the enactment of Bill C-208 are as follows:

  • Subparagraph 55(5)(e)(i) of the Act (which, prior to the amendment, deemed siblings to deal with each other at arm’s length and not to be related to each other) is amended so that it no longer applies to siblings where the dividend in question was received or paid as part of a transaction or event or a series of transactions or events from a corporation of which a share of the capital stock is a  qualified small business corporation share or a share of the capital stock of a family farm or fishing corporation, within the meaning of subsection 110.6(1).
  • Subsection 84.1(2) is amended by adding a new paragraph (e). Now, if shares are disposed of by a parent to a purchaser corporation, the parent and the purchaser corporation are deemed to deal at arm’s length, and thus are not subject to the anti-avoidance rule in section 84.1, if the following additional conditions are met:
    • the subject shares are qualified small business corporation shares or a shares of the capital stock of a family farm or fishing corporation;
    • the purchaser corporation is controlled by one or more children or grandchildren of the parent who are 18 years of age or older; and
    • the purchaser corporation does not dispose of the subject shares within 60 months of their purchase
  • A new provision, being subsection 84.1(2.3) is added. This subsection has three components:
    • First, it creates rules for dealing with situations where, otherwise than by reason of death, the purchaser corporation does in fact dispose of the subject shares within 60 months of the purchase;
    • Second, it reduces access by the parent to her lifetime capital gains deduction if the corporation’s taxable capital employed in Canada exceeds $10 Million, and fully eliminates the parent’s access to the deduction when the corporation’s taxable capital employed in Canada exceeds $15 Million. This restriction will limit the relief in the case of very capital-intensive small businesses;
    • Third, it imposes a very unusual and unique requirement that the taxpayer in question must provide the Minister (through her agent, Canada Revenue Agency) with an independent assessment of the fair market value of the subject shares and an affidavit signed by the taxpayer and by a third party attesting to the disposal of the shares.

Analysis and Implications

Bill C-208 addresses what have long been recognized as inequities in the Act as it applies to intergenerational transfers of small business corporations, family farm corporations and family fishing corporations. The changes made to section 84.1 are designed to overcome the perceived inequity whereby a seller of the shares of such businesses to arm’s-length third parties receives more favourable tax treatment than she would if she sold those same shares to the next generation of the family. The changes to section 55 expand the scope of related-party reorganization transactions to facilitate such reorganizations on a tax-effective basis within an expanded family unit. To that extent the enactment of this legislation should be considered good news by owners of affected businesses.

However, it will soon become apparent that there are significant technical complexities and deficiencies in the new provisions that may very well require fixes by way of further legislative amendments. One can only speculate whether and when there might be such a response and whether that might have retroactive effect. Because of this, taxpayers and advisors should proceed with caution in proposing or entering into transactions in reliance on the new provisions in the form they were enacted. Until further clarity is available, whether in the form of legislative amendments, technical interpretations or judicial decisions, taxpayers may be entering into an area of uncertain tax treatment and results.

A number of concerns with the new enactments have already been raised. These include the following, although further study of the provisions may lead to others:

  • Department of Finance officials have long approached potential amendments to these sections of the Act with a concern for balancing, and distinguishing between, legitimate intergenerational transfers and inappropriate tax avoidance. Because these enactments did not originate from the Department of Finance but were in the form of a Private Member’s Bill, that careful balancing appears not to have been fully addressed, leading to concerns that “loopholes” will now exist to enable wealthy Canadians to unfairly avoid taxes;
  • The “hallmarks” of legitimate intergenerational transfers are absent from these enactments. In particular, there is nothing that requires the parent to cease to control the business, nor to require that the child have any involvement in the business. Additionally, it is possible that the parent who sells shares to their child’s holding corporation could subsequently purchase the child’s shares of that holding corporation leaving the child with no interest in the business;
  • There is a requirement that the purchaser corporation not sell the subject shares within 60 months of their purchase. There is no requirement that the shares of the purchaser corporation held by the children or grandchildren not be sold during the 60 month hold period;
  • There will be significant issues with CRA’s ability to monitor and impose the provisions of new paragraph 84.1(2.3)(a) if shares are sold within 60 months of their purchase if the current normal 3-year reassessment period remains in place;
  • It appears that the prohibition on the disposition of the subject shares by the purchaser corporation during the ensuing 60 month period will apply to the child’s (or grandchild’s) purchaser corporation even in respect of an otherwise legitimate internal reorganization;
  • The new rules permit intergenerational transfers only to “children and grandchildren”. The extended definition of “child” in subsection 252(1) includes a child of the taxpayer’s spouse or common-law partner (i.e., step-children) and the spouse or common law partner of a child of the taxpayer (i.e., sons-in-law, daughters-in-law). It remains to be seen if that is too broad or too restrictive. For example, it does not include the taxpayer’s niece or nephew who may be interested in purchasing the family business;
  • The restriction that the purchaser corporation must be controlled by one or more children or grandchildren of the taxpayer who are 18 years of age or older means that the purchaser corporation cannot be controlled by a trust for the benefit of those children or grandchildren;
  • New paragraph 84.1(2)(e) applies if the shares being transferred are qualified small business corporation shares or shares in the capital stock of a family farm or fishing corporation within the meaning of subsection 110.6(1). Such shares are also shares on which the holders can typically utilize their lifetime capital gains deduction (“LCGD”)[8]. The intention appears to be to allow the LCGD to be used in respect of a sale that would otherwise be subject to section 84.1. But, because of new subsection 84.1(2.3), access to the LCGD is reduced for corporations with taxable capital over $10 Million, and is completely eliminated when taxable capital exceeds $15 Million. For shareholders of corporations that have  taxable capital greater than $15 Million, even though the LCGD would not be available to the selling shareholder there is still an advantage to structuring a sale of shares to a corporation controlled by children or grandchildren so that paragraph 84.1(2)(e) will apply and a capital gain will arise rather than a deemed dividend;
  • There are concerns that, as drafted, the formula set out in new paragraph 84.1(2.3)(b) does not achieve the intended purpose of reducing the parent’s available LCGD on a straight-line basis for those taxation years in which the taxable capital employed in Canada of the corporation (or an associated group of corporations) is in excess of $10 Million;
  • The new rules limit, or claw-back, the amount of the parent’s available LCGD that may be claimed under subsection 110.6(2) – in respect of qualified farm or fishing property, and subsection 110.6(2.1) – in respect of qualified small business corporation shares. They do not affect the additional, or “top-up”, deduction available under subsection 110.6(2.2). This top-up is available in respect of sales of qualified farm or fishing property, and increases the total deduction available in respect of such properties to $1 Million (from the $892,218, indexed to 2021, otherwise available). Although this creates an anomaly, it will cease to be relevant for years after the indexing of the limit under subsections 110.6(2) and (2.1) raises that limit above $1 Million; and
  • In cases where the new rules in section 55 apply because the subject shares are qualified small business corporation shares or a shares in the capital stock of a family farm or fishing corporation, it is now possible that siblings who indeed have separate economic interests, may engage in capital gains strips with impunity.

Bill C-208 is unique in that it originated as a private member’s bill, which are rarely successful in becoming law in Canada. Nonetheless, the Bill was passed by the House of Commons with support from all of the major political parties but without the support of the Government. Interestingly, it appears that the Bill proceeded through the Agriculture and Agri-food committee and not through the Finance Committee. It also appears that officials of the Department of Finance raised a number of concerns with the Bill and did not support it. This is not meaningless political machinations; it may well mean that the Government, and the Department of Finance in particular, may seek to re-assert their prerogative of proposing income tax legislation resulting in future measures being put forward to revise, amend or limit the provisions of the Bill. One can hope, however, that any future amendments maintain the desired and beneficial purposes of Bill C-208, and focus on making the affected tax provisions more clear, workable, fair and balanced.


[1] Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), as amended (herein referred to as the “Act”). Unless otherwise stated, statutory references in this article are references to the Act.

[2] For 2021, an Ontario resident whose income excluding the gain exceeds $220,001 will pay tax on capital gains at an effective rate of 26.76%.

[3] In 2021, for an Ontario resident in the top marginal tax bracket, 39.34% for eligible dividends and 47.74% for non-eligible dividends

[4] Currently, $892,218 (2021).

[5] Both the Quebec and the U.S. Federal Government have enacted regimes that create a framework in which intergenerational transfers can occur on a tax-preferred basis subject to specific criteria being met.  One of the common features of both regimes is that, post-sale, the parent/vendor cannot be actively involved in the corporate purchaser or the transferred business corporation. Therefore, both regimes require an actual and immediate transfer of legal control.

[6] As that term is defined in subsection 110.6(1) of the Act.

[7] Within the meaning of paragraph 110.6(1)(b) of the Act.

[8] If all other conditions are met.

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